Has Index Fund Growth Impaired Markets?
One concern about the increasing popularity of index funds is whether the decline in active management has impacted the function of markets.
What do you do if you have just received a big bonus at work, inherited some money, sold a business or otherwise enjoyed a recent windfall you would like to invest? Should you invest the money right away, even if the market seems particularly high or low, or little by little over time?
This is a question we often hear from clients and other investors. Deciding how to invest a pot of money can indeed feel paralyzing. What if you put the money in, and the market promptly tanks? Or what if you hesitate, and the market soars? It is perfectly normal to worry that you will make the wrong move, or at least not the best one.
Investing a lump sum all at once or over time each has its advantages and disadvantages. Let’s take a look at some of the factors to consider.
Before making any investment moves, first consider what you want to use your money for.
In the short term, the market can be a volatile place, with the potential for big ups and downs. If some or all of your money is going to be used for short-term goals (say, paying college tuition bills that are just a few years away), you may consider more conservative investments less affected by this volatility, like short-term bonds, bond funds or certificates of deposit (CDs).
If you want that money to help you pursue long-term goals such as retirement, then investing in the stock market right away is likely worthwhile. Over the long term, volatility tends to smooth out and the markets have historically continued to move higher.
When you invest in a lump sum, all your money is exposed to the market right away. If the market is on an upward tack, you can take advantage of immediate gains.
But of course, near-term market returns are not predictable. There could be a downturn after you invest your lump sum. If this potential for a setback bothers you, dollar-cost averaging (investing a set amount of money at regular intervals) may be a more comfortable strategy.
For example, you could use dollar-cost averaging to invest $12,000 in a low-cost, total market index fund in $1,000 monthly installments over a year. That way, when the market is at a high, your investment buys fewer fund shares. And when the market is lower, your investment buys more shares. The strategy helps you take advantage of the market’s natural ups and downs, helping you manage the average cost of the shares you buy.
However, be aware that the greater comfort of pacing your investments through dollar-cost averaging may come at a price. Research shows that lump-sum investing outperforms dollar-cost averaging 68% of the time.
So, ask yourself this question. Is maximizing expected returns your top priority? If so, the lump-sum approach might make the most sense for you. On the other hand, the same research suggests the expected outperformance is not by a large margin. So if the specter of potential investment losses might keep you awake at night, it may be worth taking a small hit to use dollar-cost averaging, especially if it will reduce the chance of panic-induced selling that effectively locks in even greater losses.
Historically, stocks and bonds outperform cash holdings over the long term. It is critical to start investing as soon as possible to take advantage of this outperformance.
Delaying the investment of cash into the market is a form of market timing (buying or selling shares in an attempt to predict future market movements). This is a complicated game you are unlikely to win. Consider that average equity fund investor returns trailed the market (as proxied by the S&P 500) by 5.5% in 2023, largely due to trying to time to the market. Both lump-sum investing and dollar-cost averaging help you avoid this behavior and take advantage of the tendency for the market to grow over the long term. And this is what you need to meet your long-term financial goals. The important thing is to choose the strategy that will allow you to stick to your long-term plan.
Unsure how to invest some of your cash holdings? Reach out to us at (732) 876-3777. We would be more than happy to discuss which option best suits your needs.
This post was written and first distributed by The Writing Company.
DISCLAIMERS
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.
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